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BW20021023002188 20021023T111846Z UTC ( BW)(XEROX-CORP)(BB63) 3rd Quarter Results Business Editors UK REGULATORY NEWS LONDON--(BUSINESS WIRE)--Oct. 23, 2002-- Xerox Reports Third-quarter Earnings of 5 Cents Per Share "Through our strengthened operations and superior offerings, we are winning customers' confidence ...building value for stakeholders." Xerox Corporation (NYSE: XRX) announced today another quarter of strong operating cash flow and earnings driven by improved margins and increased product demand in key growth markets. Xerox reported third-quarter earnings of 5 cents per share including restructuring charges of 6 cents per share. The third-quarter 2002 results are a 10-cent improvement from the third quarter of last year, reflecting the company's effective execution of its strategy to significantly strengthen its business. "Margins are up, costs are down and Xerox's streamlined business model is delivering sustainable profitability as well as strong operational cash generation," said Anne M. Mulcahy, Xerox chairman and chief executive officer. "Through our strengthened operations and superior offerings, we are winning customers' confidence, attacking competitors' share in our sweet spots of the market and building value for Xerox stakeholders." Operational improvements led to gross margins of 42 percent, a year-over-year increase of 4.4 percentage points. Selling, administrative and general costs decreased $152 million or 13 percent from third quarter 2001. The company continued to generate significant cash from operations, reporting $611 million in operating cash flow for the third quarter. As of the end of September, Xerox's worldwide cash balance was $2.3 billion. In related financial news, the company noted its announcement earlier this week with General Electric Vendor Financial Services for GE to finance Xerox's lease receivables in the U.S. through monthly securitizations based on new lease originations. The agreement, which is in effect, calls for GE to provide Xerox with funding in the U.S. of up to $5 billion outstanding during the eight-year term of the arrangement. Xerox reported third-quarter revenue of $3.8 billion, a year-over-year decline of 6 percent. Approximately 50 percent of the third-quarter revenue decline was due to the company's exit last year from the retail small office/home office equipment business as well as declines in its developing markets operations. Third-quarter results reflect quarter-by-quarter percentage improvements this year in the company's core office and production businesses, with new product launches delivering growth in target markets including office color, office monochrome multifunction and production color. "There is no doubt that Xerox's technology is the best in the industry. This advantage is further strengthened by our rich portfolio of services and solutions that give our customers the added value that all businesses need," said Mulcahy. "In the third quarter, we began to see the results of our technology investments with strong customer demand for products launched this year including the Document Centre 500 series, expanded line of Phaser color printers, and the DocuColor 1632, 2240 and 6060." Mulcahy added that Xerox continues to take the necessary actions to hit all key areas of the market with competitive technology offerings, noting its launch yesterday of the Xerox 1010, the company's latest entry into the "light production" segment of the high-end digital production publishing market. As a stand-alone digital copier that can be upgraded to a networked printer, the 101 page-per-minute system is the least expensive and most advanced product in its class. Evidence of the growing demand for Xerox technology, the company highlighted several recent customer contracts that represent new business, competitive knockouts and renewals: - Microsoft has engaged Xerox for continued managed services and document solutions valued at $38 million over 3 years. A premier supplier under Microsoft's new vendor program, Xerox will supply office equipment including Document Centres, Phaser printers and other products. Over $2 million in product sales are expected through year-end. - Latham & Watkins, a large global law firm, replaced 110 competitive products with Xerox's Document Centre digital multifunction systems. - Xerox completed new and expanded contracts with major print-for-pay and commercial printers, including agreements with Office Depot and Kinko's that combined call for the placement of more than 3,000 products over the next 18 months. - Dow Chemical Company called upon Xerox to develop a digital imaging solution that helps to eliminate multiple collections of materials. Since Xerox created a database that includes Dow's research materials dating back to 1937, access by Dow's scientists and strategic partners has quadrupled. Worldwide employment declined 1,600 in the third quarter to 69,900 as the company continued to make progress in capturing additional cost-reduction opportunities. Research and development spending was 6 percent of revenue, reflecting Xerox's commitment to fostering innovation in its three key markets: office, production and services. Commenting on the fourth quarter, Mulcahy said, "While we expect that economic uncertainty will continue to impact year-over-year revenue results, total revenue in the fourth quarter will continue to trend positively, largely driven by significant equipment sales improvement due to new product launches. Enhanced business model improvements will strengthen our bottom line, delivering strong full-year profitability." For additional information about The Document Company Xerox, please visit our Worldwide Web site at www.xerox.com/investor. This release contains forward-looking statements and information relating to Xerox that are based on our beliefs as well as assumptions made by and information currently available to us. The words "anticipate," "believe," "estimate," "expect," "intend," "will" and similar expressions, as they relate to us, are intended to identify forward-looking statements. Actual results could differ materially from those projected in such forward-looking statements. Information concerning certain factors that could cause actual results to differ materially is included in the company's Form 10-Q for the quarter ended June 30, 2002, as filed with the SEC. XEROX(R), The Document Company(R) and the digital X(R) are trademarks of XEROX CORPORATION. -0- *T Xerox Corporation Condensed Consolidated Statements of Income (Unaudited) ---------------------------------------------------------------------- Three Months Ended Nine Months Ended Sept 30, Sept 30, 2002 2001 %Change 2002 2001 %Change (in millions, Restated Restated except per share data) ---------------------------------------------------------------------- Revenues Sales $1,593 $1,708 (7%) $4,838 $5,431 (11%) Service, outsourcing and rentals 1,953 2,071 (6%) 6,004 6,344 (5%) Finance 247 273 (10%) 761 851 (11%) ---------------------------------------------------- Total Revenues 3,793 4,052 (6%) 11,603 12,626 (8%) Costs and Expenses Cost of Sales 1,013 1,239 (18%) 3,036 3,917 (22%) Cost of service, outsourcing and rentals 1,079 1,183 (9%) 3,411 3,658 (7%) Equipment financing interest 107 107 - 300 362 (17%) Research and development expenses 229 257 (11%) 699 765 (9%) Selling, administrative and general expenses 1,023 1,175 (13%) 3,302 3,544 (7%) Restructuring and asset impairment charges 63 63 - 262 487 (46%) Gain on sale of half of interest in Fuji Xerox - - - - (769) (a) Other expenses, net 93 125 (26%) 290 327 (11%) ----------------------------------------------------- Total Costs and Expenses 3,607 4,149 (13%) 11,300 12,291 (8%) Income (Loss) before Income Taxes (Benefits), Equity Income, Minorities' Interests, and Cumulative Effect of Change in Accounting Principle 186 (97) (a) 303 335 (10%) Income Taxes (Benefits) 81 (74) (a) 128 247 (48%) ----------------------------------------------------- Income (Loss) before Equity Income, Minorities' Interests and Cumulative Effect of Change in Accounting Principle 105 (23) (a) 175 88 99% Equity in net income of unconsolidated affiliates 17 - (a) 43 34 26% Minorities' Interests in earnings of subsidiaries (17) (9) 89% (66) (26) (a) ----------------------------------------------------- Income (Loss) before Cumulative Effect of Change in Accounting Principle 105 (32) (a) 152 96 58% Cumulative effect of change in accounting principle, net - - - - (2) (a) Net Income (Loss) $105 $(32) (a) $152 $94 62% ====================================================================== Basic Earnings (Loss) per Share: Preferred dividends, net of tax (63) - (a) (63) (12) (a) Income (Loss) available for common shareholders 42 (32) (a) 89 82 9% Weighted average shares outstanding 734 718 2% 729 699 4% ----------------------------------------------------- Net Earnings (Loss) Per Share $0.06 ($0.05) (a) $0.12 $0.12 - ====================================================================== Diluted Earnings (Loss) per Share: ESOP expense adjustment, net of tax (63) - (a) (63) (8) (a) ---------------------------------------------------- Income (Loss) available for common shareholders 42 (32) (a) 89 86 3% Weighted average shares outstanding 825 718 15% 803 783 3% ---------------------------------------------------- Net Earnings (Loss) Per Share $0.05 ($0.05) (a) $0.11 $0.11 - ====================================================================== (a) Percent not meaningful Xerox Corporation Condensed Consolidated Balance Sheets (Unaudited) September 30, December 31, (In millions) 2002 2001 ---------------------------------------------------------------------- Assets Cash and cash equivalents $2,281 $3,990 Accounts receivable, net 1,822 1,896 Billed contractual finance receivables 544 584 Contractual finance receivables, net 3,160 3,338 Inventories 1,207 1,364 Deferred taxes and other current assets 1,436 1,428 ---------------------------------------------------------------------- Total Current Assets 10,450 12,600 Contractual finance receivables due after one year, net 5,176 5,756 Equipment on operating leases, net 506 804 Land, buildings and equipment, net 1,773 1,999 Goodwill, net 1,587 1,445 Other long-term assets 4,974 5,085 ---------------------------------------------------------------------- Total Assets $24,466 $27,689 ====================================================================== Liabilities and Equity Short-term debt and current portion of long-term debt $3,514 $6,637 Accounts payable 716 704 Other current liabilites 2,535 2,919 ---------------------------------------------------------------------- Total Current Liabilities 6,765 10,260 Long-term debt 10,470 10,128 Other long-term liabilities 3,031 3,251 ---------------------------------------------------------------------- Total Liabilities 20,266 23,639 Deferred ESOP benefits (135) (135) Minorities' interests in equity of subsidiaries 68 73 Company-obligated, mandatorily redeemable preferred securities of subsidiary trusts holding solely subordinated debentures of the Company 1,698 1,687 Preferred stock 559 605 Common shareholders' equity 2,010 1,820 ---------------------------------------------------------------------- Total Liabilities and Equity $24,466 $27,689 ====================================================================== Xerox Corporation Condensed Consolidated Statement of Cash Flows (Unaudited) ---------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30, September 30, (In millions) 2002 2001 2002 2001 Restated Restated ---------------------------------------------------------------------- Cash Flows from Operating Activities Net Income (Loss) $105 ($32) $152 $94 Adjustments required to reconcile net income to cash flows from operating activities: Depreciation and amortization 213 317 772 997 Provisions for receivables and inventory 118 186 375 574 Restructuring and asset impairment charges 63 63 262 487 Cash payments for restructurings (93) (101) (276) (365) (Gains) losses on sales of businesses and assets, net (14) - (20) (759) (Increase) decrease in inventories (17) (9) 64 118 Increase in on-lease equipment (7) (50) (98) (231) Decrease in unbilled finance receivables 188 194 656 222 Decrease (increase) in accounts receivable and billed finance receivables 91 (74) (11) (1) Net change in current and long-term deferred income taxes 60 (140) (259) 208 (Decrease) increase in other current and long-term liabilities 13 32 (175) (26) All other operating changes, net (109) (152) (200) (351) Net cash provided by operating activities 611 234 1,242 967 Cash Flows from Investing Activities Cost of additions to land, buildings and equipment (38) (38) (109) (159) Proceeds from sales of businesses and assets 67 - 340 1,635 All other investing activities, net 17 (40) (10) (296) Net cash provided by (used) in investing activities 46 (78) 221 1,180 Cash Flows from Financing Activities Net change in debt (289) 34 (3,238) (1,385) All other financing activities, net (2) - 2 (95) Net cash (used in) provided by financing activities (291) 34 (3,236) (1,480) Effect of exchange rate changes on cash and cash equivalents 24 59 64 8 Increase (decrease) in cash and cash equivalents 390 249 (1,709) 675 Cash and cash equivalents at beginning of period 1,891 2,176 3,990 1,750 Cash and cash equivalents at end of period $2,281 $2,425 $2,281 $2,425 ====================================================================== *T Financial Review Summary On April 11, 2002, we reached a settlement with the Securities and Exchange Commission (SEC) relating to matters that had been under investigation by the SEC since June 2000. In connection with the settlement, we agreed to restate our consolidated financial statements as of and for the years ended December 31, 1997 through 2000 and undertake a review of our material internal controls and accounting policies. We also restated our condensed consolidated financial statements for the first three-quarters of 2001 that were included in our quarterly filings on Form 10-Q. The restatement is discussed in more detail in the "Recent Events" section of this Financial Review. The effects of the restatement adjustments on revenue and pre-tax profit for the three months ended September 30, 2001 was to increase revenue by $150 million and decrease pre-tax loss by $149 million. We estimate that approximately $205 million of revenue that was recognized in the three months ended September 30, 2002 had been restated from prior periods. At the end of the third quarter 2002, approximately $1.3 billion of revenue recognized in periods prior to January 1, 2002, that was reversed, is estimated to be recognized as follows: $185 million - fourth quarter 2002, $570 million - 2003 and $530 million - thereafter. However, prospective marketplace activity such as lease terminations and trades and currency movements will impact the realization of these amounts. Total future revenue will also be impacted by the application of our new bundled lease revenue allocation methodology and other accounting changes discussed in our 2001 Annual Report on Form 10-K. Throughout the following Financial Review, all referenced amounts reflect the above described restatement adjustments. Total third quarter 2002 revenues of $3.8 billion declined 6 percent from $4.1 billion in the 2001 third quarter, representing a reduced rate of decline from prior periods, as equipment sale declines moderated reflecting the success of our new product launches in several of our target markets. Approximately half the total revenue decline was due to our second half 2001 exit from the Small Office/Home Office (SOHO) business and declines in our Developing Markets Operations (DMO) as we continue to prioritize profitable revenue. The rest of the decline reflects continued economic weakness and marketplace competition as production monochrome and office light lens declines were only partially offset by growth in the key areas of office monochrome digital multifunction as well as production and office color. Cost and expense actions, consistent with improving our business model, enabled further progress in gross margins and reduced selling, administrative and general (SAG) expenses. Third quarter 2002 net income of $105 million or $0.05 cents per diluted share included after-tax restructuring charges of $49 million ($63 million pre-tax). The third quarter 2001 net loss of $32 million, or $0.05 cents per diluted share, included after-tax restructuring charges of $47 million ($63 million pre-tax), net after-tax losses from foreign unhedged currency exposures of $38 million ($59 million pre-tax) and after-tax goodwill amortization of $15 million ($16 million pre-tax) that was amortized prior to our adoption of SFAS No.142. Beginning in the second quarter of 2001, the Board of Directors suspended the dividend on the Company's Preferred Stock held by its Employee Stock Ownership plan (ESOP). In order to meet ESOP debt service requirements since dividends were suspended, we incurred additional ESOP-related compensation expense for each period that the dividends were not declared. On September 9, 2002, the Board of Directors declared preferred dividends totaling $67 million representing the cumulative unpaid dividends that were in arrears, as well as the third quarter 2002 dividend. This resulted in a reversal of the previously recorded compensation expense and a corresponding increase to net income of $63 million. However, there is no corresponding earnings per share (EPS) improvement since the EPS calculation requires deduction of dividends declared from reported net income in arriving at income available to common shareholders. Operations Review Pre-Currency Growth To understand the trends in the business, we believe that it is helpful to adjust revenue and expense growth (except for ratios) to exclude the impact of changes in the translation of European and Canadian currencies into U.S. dollars. We refer to this adjusted growth as "pre-currency growth." Latin American results are shown at actual exchange rates for both pre-currency and post-currency reporting, since these countries generally have volatile currency and inflationary environments. A substantial portion of our consolidated revenues is derived from operations outside of the United States where the U.S. dollar is not the functional currency. When compared with the average of the major European and Canadian currencies on a revenue-weighted basis, the U.S. dollar was approximately 7 percent weaker in the 2002 third quarter than in the 2001 third quarter. As a result, foreign currency translation favorably impacted revenue growth by approximately 2 percentage points in the third quarter 2002. Revenues by Type Year-over-year post-currency percent changes by type of revenue were as follows: -0- *T Post Currency 2001 2002 --------------------- ------------- Q1 Q2 Q3 Q4 FY Q1(a)Q2(a) Q3 --------------------- ------------- % % % % % % % % Equipment Sales (10)(20)(19)(21)(18) (17)(12) (9) Post Sale and Other Revenue (5) (7) (6) (8) (6) (8) (6) (5) Financing Income 1 (1) (7) (5) (3) (10)(13)(10) Total Revenue (6)(10) (9)(12) (9) (10) (8) (6) (a) Equipment and Post Sale and Other amounts have been revised from previously reported percentages to conform certain sale revenue classifications to the current quarter presentation. *T Note: Sales revenue in the Condensed Consolidated Statement of Income includes equipment sales noted above as well as supplies, paper and other revenue that is included in "Post Sale and Other Revenue" in the above table. Equipment sales typically represent approximately 20-25 percent of total revenue. Equipment sales in the third quarter 2002 declined 9 percent (11 percent pre-currency) from the third quarter 2001 with approximately 40 percent of the decline due to our exit from the SOHO business. In addition, continued competitive pressures and economic weakness impacted equipment sales particularly in production monochrome. In November, we will launch our new 101 per minute (ppm) monochrome system, the Xerox 1010, our latest digital entry in the "light production" market and the least expensive and most advanced system in its class. In the third quarter, new products delivered growth in production color, monochrome digital multi-function and office color printing. The DocuColor 1632 (16 ppm color / 32 ppm black & white) and 2240 (22 ppm pages color / 40 ppm black & white) midrange color printer/copiers deliver affordability and speed with a benchmark cost for color pages of less than 10 cents a page. The Document Centre 500 Series digital multifunction systems bring unparalleled productivity and features to small and mid-sized workgroups at significantly lower manufacturing costs. Demand for the new Document Centre 500 Series exceeded our expectations and contributed to a backlog, which we expect to install in the fourth quarter. In addition, the Phaser 6200 laser and 8200 solid ink color printers launched in May continued to deliver strong growth. The DocuColor 6060 complements the successful DocuColor 2000 family by offering a more advanced set of features, productivity and capabilities. Post sale and other revenues include service, document outsourcing, rentals, supplies and paper, which represent the revenue streams that follow equipment placement, as well as revenue not associated with equipment placement, such as royalties. Third quarter 2002 post sale and other revenues declined 5 percent (7 percent pre-currency) from the 2001 third quarter, as declines in North America and the Developing Markets were only partially offset by growth in Europe. The declines reflect lower equipment populations due to reduced placements in earlier periods, lower page print volumes, and lower rental income in Latin America. Growth in Europe reflected the profile of the installed base, which has a higher proportion of digital products than North America, as well as longer average lease duration. 2002 third quarter document outsourcing revenue declined from the 2001 third quarter as declines in North America outpaced revenue growth in Europe. We expect document outsourcing revenue will continue to decline as we continue to focus on more profitable contracts. Finance Income declined 10 percent (12 percent pre currency) in the third quarter 2002 from the third quarter 2001 reflecting continued equipment sale declines, primarily in North America, and the effects of the sale of our financing businesses in the Nordic countries and Italy. Key Ratios and Expenses The trend in key ratios was as follows: -0- *T 2001 2002 ------------------------- --------------- Q1 Q2 Q3 Q4 FY Q1 Q2 Q3 ------------------------- --------------- % % % % % % % % Total Gross Margin 34.8 39.1 37.6 41.4 38.2 41.0 42.5 42.0 R&D % Revenue 5.8 6.0 6.3 5.3 5.9 6.0 6.1 6.0 SAG % Revenue 26.8 28.5 29.0 27.0 27.8 30.3 28.1 27.0 *T Third quarter 2002 gross margin of 42.0 percent improved 4.4 percentage points from 37.6 percent in the third quarter 2001. Approximately two percentage points of the improvement reflect the prior liquidation of equipment inventory associated with our SOHO exit. In addition, the improvement reflects improved manufacturing and service productivity partially offset by the impact of competitive price pressures. The applicable portion of the previously discussed ESOP expense adjustment benefited the third quarter 2002 gross margin by $28 million or 0.7 percentage points. Research and development (R&D) expense of $229 million was $28 million lower in the 2002 third quarter than the third quarter 2001 reflecting benefits from cost restructuring actions, the $11 million applicable portion of the ESOP expense adjustment and our SOHO exit. R&D spending in the 2002 third quarter represented 6 percent of revenue as we continue to invest in technological development, particularly color, in order to maintain our position in the rapidly changing document processing market. We expect 2002 R&D spending will represent approximately 6 percent of revenue, a level that we believe is adequate to remain technologically competitive. Xerox R&D remains strategically coordinated with Fuji Xerox. Selling, administrative and general (SAG) expenses declined by $152 million in the 2002 third quarter to $1,023 million primarily reflecting business model improvements from our cost reductions, the $28 million applicable portion of the ESOP expense adjustment, a $34 million favorable property tax adjustment, lower bad debt provision and a $26 million loss associated with leased facilities. The $34 million property tax adjustment resulted from a change in the estimated amounts payable to the numerous domestic state and local property tax jurisdictions where we place our equipment through sale or lease. Such change was due to our reviews of property tax rates, experience in property tax audits and amounts of leased equipment at customer sites. The $26 million loss associated with leased facilities represents a change in the estimated loss we expect to incur related to our decision not to utilize existing lease facilities, as well as changes in our estimates of certain sublease rentals at a lower rate than our lease costs. The third quarter 2002 bad debt provision of $87 million was $64 million lower than 2001 primarily due to improved aging and historical write-off trends for accounts and finance receivables as well as lower provisions in North America due to improved customer administration and tighter credit control policies. The third quarter 2001 was negatively impacted by provisions required for many high-risk small customers. We have been initiating restructuring actions in order to cut costs and prioritize resources in strategic areas of our business. We recorded a restructuring charge in the third quarter 2002 of $63 million ($49 million after taxes) to reflect these actions. The charge primarily consisted of severance and employee benefits related to the termination of approximately 1,100 employees worldwide, as well as certain costs related to the consolidation of excess facilities. These actions are expected to reduce annualized costs by approximately $75 million. We expect additional provisions will be required in 2002 as additional plans are finalized and are committed to. The fourth quarter provision is expected to be higher than the average of the first 3 quarters of 2002 but cannot be estimated until finalization of the plans. The restructuring reserve balance at September 30, 2002 was approximately $200 million. Worldwide employment was 69,900 at the end of the 2002 third quarter primarily reflecting reductions due to our restructuring programs and the prior de-consolidation of our South African subsidiary. Other expenses, net for the quarters ended September 30, 2002 and 2001 were as follows: -0- *T Q3 Q3 ($ in millions) 2002 2001 ----- ----- Non-financing interest expense $83 $48 Currency losses, net 12 59 Amortization of goodwill (2001 only) and intangibles 9 21 Interest income (21) (24) Gain on sale of businesses and assets, net (14) - All other, net 24 21 ----------- Total $93 $125 =========== *T Other expenses, net were $93 million in the third quarter 2002 and $125 million in the third quarter 2001. Higher non-financing interest expense primarily reflects higher borrowing costs associated with the terms of the New Credit Facility. Non-financing interest expense also includes net gains from the mark-to-market of interest rate swaps, including "received fixed/pay variable" type swaps. These gains are the result of a declining interest rate environment and totaled $29 million and $46 million in the third quarter of 2002 and 2001, respectively. The decline in gains is the result of a smaller swap portfolio and a lower relative interest rate decline in 2002 as compared to 2001. Net currency losses of $12 million in the 2002 third quarter primarily represent the cost of hedging our foreign currency denominated exposures in markets where we have been able to restore economic hedging capability. Gains and losses on unhedged exposures were immaterial on a net basis in the quarter. The large loss in the third quarter 2001 resulted from our unhedged exposures largely due to our restricted access to the derivatives markets in 2001. Effective January 1, 2002, we adopted the provisions of SFAS No. 142 "Goodwill and Other Intangible Assets." Accordingly, the amortization of goodwill was discontinued in 2002. Interest income is derived from our invested cash balances and income tax receivables. In the future, we expect interest income will decline, as cash balances are lower than prior years following debt repayments, including $3.5 billion on our credit facilities. In July 2002, we sold our 22 percent investment in Katun Corporation, a supplier of aftermarket copier/printer parts and supplies, for net proceeds of $67 million, which resulted in a pre-tax gain of $12 million. After-tax, the sale was essentially break-even, as the taxable basis of Katun was lower than our carrying value on the sale date resulting in a high rate of income tax. All other, net for the 2002 third quarter includes $20 million of expenses related to certain litigation and associated claims. The 2001 third quarter included $10 million of property losses related to the September 11 attacks as well as numerous other individually insignificant items. Income Taxes, Equity in Net Income of Unconsolidated Affiliates and Minorities' Interests in Earnings of Subsidiaries Pre-tax income was $186 million in the third quarter 2002 compared to a pre-tax loss of $97 million in the third quarter 2001. In the third quarter 2002, we recorded an income tax expense of $81 million compared to an income tax benefit of $74 million in the third quarter of 2001. The consolidated effective tax rate for the third quarter 2002 was 43.5 percent and the year-to-date effective tax rate was 42.2 percent. The third quarter 2002 and year-to-date tax rates reflect additional tax expense recorded for the sale of our interest in Katun Corporation, the on-going examination in India as well as losses in certain jurisdictions where we are not providing tax benefits. Such expense is offset, in part, by certain benefits arising from tax law changes and the declaration of ESOP dividends. Our annual effective tax rate will change based on nonrecurring events (such as new restructuring initiatives) as well as recurring factors including the geographical mix of income before taxes and the related tax rates in those jurisdictions. We expect that our consolidated 2002 effective tax rate will approximate 45 percent. Before restructuring charges, we expect that our 2002 effective tax rate will approximate 40 percent. Equity in Net income of unconsolidated affiliates consists of our 25 percent share of Fuji Xerox income as well as income from other smaller equity investments. Higher equity in net income for the third quarter 2002 primarily reflects improved Fuji Xerox performance including strong revenue growth and improved gross margins. Minorities interest in earnings of subsidiaries increased by $8 million to $17 million in the third quarter 2002 primarily due to the quarterly distribution on the November 2001 Convertible Trust Preferred Securities. Business Performance by Operating Segment Our operating segments are as follows: Production, Office, DMO, SOHO, and Other. The following table summarizes our business performance by segment. Revenue and year-over-year revenue percentage changes by segment are as follows: -0- *T 2001 2002 ------------------------------------- Full % Year Q3 Change --------------------------- Revenue(a) Revenue(a) Q1 Q2 Q3 ---------- --------- --------------------------- Production $5.9 $1.3 (9) (8) (5) Office 6.9 1.6 (6) (4) (2) DMO 2.0 0.4 (11) (10) (15) SOHO 0.4 0.1 (43) (42) (43) Other 1.8 0.4 (19) (11) (10) ---------- --------- Total $17.0 $3.8 (10) (8) (6) ========== ========= Memo: Color $2.8 $0.7 (8) 1 4 (a) Dollars are in billions *T Operating segment profit (loss) and margins are as follows: -0- *T 2001 2002 ------------------------- --------------- -------------- Profit (Loss)(a) Margin ----------------------------------------- -------------- Q1 Q2 Q3 Q4 FY Q1 Q2 Q3 Q3 2002 Q3 2001 ------------------------- --------------- -------------- Production $112 $101 $73 $180 $466 $105 $125 $142 10.7% 5.2% Office 47 98 63 157 365 91 138 115 7.1% 3.8% DMO (70) 5 (12) (48)(125) (5) 7 21 5.1% (2.5%) SOHO (79) (84) (54) 22 (195) 27 15 23 36.5% (49.1%) Other (1) (42)(101) 35 (109) (112) (47) (35) (9.3%) (24.0%) ----------------------------------------- -------------- Total $9 $78 ($31)$346 $402 $106 $238 $266 7.0% (0.8%) ========================================= ============== (a) Dollars are in millions *T Note: For purposes of comparability, 2001 operating segment information has been adjusted to reflect a change in measurement of segment profit or loss that was implemented in 2002. The nature of the changes related primarily to corporate expense and other allocations associated with internal reorganizations made in 2002, as well as decisions concerning direct applicability of certain overhead expenses to the segments. The adjustments increased (decreased) full year 2001 revenues as follows: Production- ($16), Office - ($16), DMO - ($1), SOHO -$3 and Other- $30. The full year 2001 segment profit was increased (decreased) as follows: Production - $12, Office - $24, DMO - $32, SOHO - $2 and Other - ($70). Production revenues include production publishing, production printing, color products for the production and graphic arts markets and light lens copiers over 90 pages per minute sold predominantly through direct sales channels in North America and Europe. Revenues in the third quarter 2002 declined 5 percent (8 percent pre-currency) from the 2001 third quarter. Production monochrome declines reflect customer transition from light lens to digital offerings, continued market weakness, particularly in the Graphic Arts market and the trend towards distributed printing and electronic substitutes. We have just announced the November launch of the Xerox 1010, our latest digital entry for the growing "light production" market. Third quarter 2002 production color revenues grew from the 2001 third quarter reflecting the recently launched DocuColor 1632 and DocuColor 2240 printer/copiers as well as continued success in the DocuColor 2000 family. Production revenues represented approximately 35 percent of total revenue in the third quarter 2002 and 34 percent of revenue in the third quarter 2001. Third quarter 2002 production segment profit increased by $69 million to $142 million and the segment margin improved by 5.5 percentage points to 10.7 percent reflecting gross margin improvement and expense benefits from our cost saving initiatives, partially offset by increased R&D spending. Office revenues include our family of Document Centre digital multifunction products, color laser, solid ink and monochrome laser printers, digital and light lens copiers under 90 pages per minute, and facsimile products sold through direct and indirect sales channels in North America and Europe. Third quarter 2002 revenues declined 2 percent (4 percent pre-currency) from the 2001 third quarter as light lens declines were only partially offset by strong monochrome digital and color revenue growth from recently launched products. In the third quarter 2002, we launched the Document Centre 500 Series digital multifunction systems at speeds of 35, 45 and 55 pages per minute. The new Phaser office color printers, launched in May, are designed to fuel the migration to color in the office by offering cost and print quality advantages that make it practical to replace black-and-white printers. Office revenues represented approximately 43 percent of total revenue in the third quarter 2002 and 40 percent in the third quarter 2001. Third quarter 2002 office segment profit increased by $52 million to $115 million and the segment margin improved by 3.3 percentage points to 7.1 percent reflecting expense benefits from our cost saving initiatives and improved gross margins driven primarily by improved manufacturing and service productivity. DMO includes operations in Latin America, the Middle East, India, Eurasia, Russia and Africa. DMO revenue declined 15 percent in the 2002 third quarter predominantly due to lower equipment populations and the currency devaluation in Brazil. Third quarter 2002 DMO segment profit increased by $33 million to $21 million and the segment margin improved by 7.6 percentage points to 5.1 percent. The third quarter profit improvement includes significantly lower SAG spending resulting from our cost saving initiatives and the currency devaluation as our improved liquidity has allowed us to better economically hedge currency exposures. We announced our disengagement from our worldwide SOHO business in June 2001. SOHO revenues now consist primarily of consumables for the inkjet printers and personal copiers previously sold through indirect channels in North America and Europe. Third quarter 2002 SOHO revenues declined 43 percent from 2001, primarily due to the absence of equipment revenue. Third quarter 2002 profitability reflects continued sales of high margin consumables for the existing equipment population. We expect sales of these supplies to continue over the next few years, and will decline over time as the existing population of equipment is replaced. Other includes revenues and costs associated with paper sales, Xerox Engineering Systems (XES), Xerox Connect, our investment in Fuji Xerox, consulting and other services. Other also includes corporate items such as non-financing interest and other non-allocated costs. 2002 third quarter revenue declined 10 percent (14 percent pre currency) principally due to lower XES and Xerox Connect revenues partially offset by higher paper revenue. The reduced third quarter 2002 loss principally reflects the beneficial impact of the ESOP expense adjustment, partially offset by higher non-financing interest expense. Third quarter 2002 Adjusted Average Shares Outstanding of 825 million for the diluted EPS calculation increased by approximately 107 million shares from the 2001 third quarter reflecting the effect of our dilutive securities, which are included in the calculation when we are profitable. The increase primarily reflects share dilution resulting from the application of the "if converted" methodology in the calculation of our diluted EPS for the Preferred Shares held by the ESOP. When computing diluted EPS, the "if converted" methodology requires us to assume conversion of the ESOP preferred shares into common stock if we are profitable. The conversion guarantees that each ESOP preferred share be converted into shares worth a minimum value of $78.25. As long as our common stock price is above $13.04 per share, the conversion ratio is 6 to 1. As our share price falls below this amount, the conversion ratio increases. In the third quarter 2002, approximately 87 million common shares were included in the adjusted average shares outstanding, resulting from the assumed conversion of the 7.2 million average outstanding ESOP Preferred Shares at the third quarter 2002 average share price of approximately $6.46 per share. Capital Resources and Liquidity Cash Flow Analysis The following summarizes our cash flows for the three and nine months ended September 30, 2002 and 2001 as reported in our Condensed Statement of Cash Flows in the accompanying Condensed Consolidated Financial Statements: -0- *T Three Months Nine Months Ended Ended September 30, September 30, --------------- --------------- 2002 2001 2002 2001 Restated Restated Operating Cash Flows $611 $234 $1,242 $967 Investing Cash Flows / Usage 46 (78) 221 1,180 Financing Cash Usage / Flows (291) 34 (3,236) (1,480) Effect of exchange rate changes on cash and cash equivalents 24 59 64 8 --------------- --------------- Increase (Decrease) in cash and cash equivalents 390 249 (1,709) 675 Cash and cash equivalents at beginning of period 1,891 2,176 3,990 1,750 --------------- --------------- Cash and cash equivalents at end of period $2,281 $2,425 $2,281 $2,425 =============== =============== *T For the three months ended September 30, 2002, operating cash flows of $611 million reflected positive net income as well as working capital reductions partially offset by a $90 million cash contribution to our pension plans. The increase in operating cash flows reflected improvement in our operating income, net cash generation from our finance-receivable portfolios reflecting continued equipment sale declines and our transition to third party vendor financing, and a modest improvement in accounts receivable. In addition, on-lease equipment spending declined due to lower rental populations, particularly in our older-generation light- lens products. Interest payments were essentially unchanged, as lower debt levels were offset by higher interest rates versus the prior year quarter. Third quarter cash restructuring payments were $93 million and $101 million in 2002 and 2001, respectively. Investing cash flows for the three months ended September 30, 2002 were primarily related to proceeds of $67 million from the sale of our investment in Katun, partially offset by capital spending. Investing cash flows in the 2001 third quarter largely consisted of capital spending. Third quarter 2002 financing activities included $700 million of debt repayments under the renegotiated New Credit Facility, and $435 million of other net payments of maturing debt, offset by proceeds from secured borrowings from GE Capital in the U.S., Canada and the U.K. totaling $828 million. Financing activities for the 2001 third quarter consisted of scheduled debt repayments of approximately $450 million, which were more than offset by $480 million of proceeds received from the issuance of asset-backed notes in the U.S. The EBITDA-based cash flow presentation below illustrates the way we look at cash flows from a cash management perspective. We define EBITDA as earnings excluding financing income and before interest expense, income taxes, depreciation, amortization, minorities' interests, equity in income of unconsolidated affiliates, and non-recurring and non-operating items. We believe that EBITDA provides investors with a useful measure of liquidity generated from recurring operations. EBITDA is not intended to represent an alternative to either operating income or cash flows from operating activities (as those terms are defined in GAAP). While EBITDA is frequently used to analyze companies, the definition of EBITDA that we employ, as presented herein, may be different than definitions of EBITDA used by other companies. EBITDA and the related cash flows for the three and nine months ended September 30, 2002 and 2001 were as follows (in millions): -0- *T Three Months Ended Nine Months Ended September 30, September 30, ------------------- ------------------ 2002 2001 2002 2001 Restated Restated Non-financing revenues $3,546 $3,779 $10,842 $11,775 Non-financing cost of sales 2,092 2,422 6,447 7,575 ------------------- ------------------ Non-financing gross profit 1,454 1,357 4,395 4,200 Research and development expenses (229) (257) (699) (765) Selling, administrative and general expenses (1,023) (1,175) (3,302) (3,544) Depreciation and amortization expense(a) 204 296 744 931 ------------------- ------------------ EBITDA 406 221 1,138 822 Working capital and other changes 26 (39) (53) 433 Increase in on-lease equipment (7) (50) (98) (231) Cost of additions to land, buildings and equipment (38) (38) (109) (159) Cash payments for restructurings (93) (101) (276) (365) Interest payments (189) (183) (523) (789) Equipment financing 507 434 1,520 1,136 Debt repayments, net (289) 5 (3,238) (1,414) Dividends and other non- operating items - - (45) (393) Proceeds from divestitures 67 - (25)(b) 1,635 ------------------- ------------------ Net increase (decrease) in cash and cash equivalents $390 $249 ($1,709) $675 =================== ================== (a) Excludes goodwill and intangible assets amortization (b) Amount includes the tax payments associated with the Fuji Xerox sale. Such amount is included in operating activities in our GAAP Condensed Consolidated Statement of Cash Flows. *T Debt At September 30, 2002 we had approximately $1.1 billion of maturing debt obligations expected to be repaid during the remainder of 2002. Our scheduled quarterly debt maturities for the remainder of 2002 and full year 2003 are as follows (in billions): -0- *T 2002 2003 ---- ---- First Quarter $0.6 Second Quarter 1.2 Third Quarter 0.6 Fourth Quarter $1.1 1.5 ---- ----- Full Year $1.1 $3.9 ==== ==== *T The following table summarizes our secured and unsecured debt as of September 30, 2002 (in millions): -0- *T New Credit Facility - debt secured under the 20% net worth limitation $900 (1) New Credit Facility - debt secured outside the 20% limitation 600 Debt secured by finance receivables 3,209 (2) Capital leases 24 Debt secured by other assets 97 -------- Total Secured Debt 4,830 New Credit Facility - unsecured 2,000 (1) Senior Notes 835 Subordinated debt 581 Other Debt 5,738 -------- Total Unsecured Debt 9,154 -------- Total Debt $13,984 ======== *T (1) The amount of New Credit Facility debt secured under the 20% Consolidated Net Worth limitation represents an estimate based on Consolidated Net Worth at September 30, 2002 and an estimate of the amount of other debt, as defined, secured under the 20% limitation. Any change to the amount indicated would correspondingly change the amount of the unsecured portion of the New Credit Facility. (2) Of this amount, $2,614 is secured by assets owned by special purpose entities (SPEs). Vendor Financing Our plan to transition customer financing to third party vendors is an important initiative in enhancing our liquidity. A history of our progress can be found in our second quarter 10-Q filed with the SEC. In the third quarter 2002, we received proceeds of $828 million from secured borrowings from GE, consisting of $519 million in the U.S, $147 million in Canada and $162 million in the UK. On Monday, October 21, 2002 we announced an eight-year agreement with GE Vendor Financial Services, whereby GE will finance the majority of lease receivables in the United States through monthly securitizations based on new lease originations. The new agreement is in addition to the $2.5 billion that we have already received from GE in the U.S. and calls for GE to provide funding through 2010 of up to $5 billion outstanding at any time. The agreement also includes opportunities to increase the financing levels over time, consistent with our expected revenue growth. Through this agreement, the financing debt and the receivables remain on our balance sheet with the debt funded by the contracted GE securitizations. The agreement became effective immediately and allows GE to securitize our U.S. lease receivables at over-collaterization rates of approximately 10 percent. New Credit Facility In June 2002, we entered into an Amended and Restated Credit Agreement (the "New Credit Facility") with a group of lenders, replacing our prior $7 billion facility (the "Old Revolver"). The New Credit Facility (currently $3.5 billion outstanding) consists of two tranches of term loans totaling $2.0 billion and a $1.5 billion revolving facility that includes a $200 million letter of credit sub-facility. The New Credit Facility is discussed in detail in our second quarter 10-Q and the complete agreement is filed on Form 8-K with the SEC. At September 30, 2002, we are in compliance with all aspects of the New Credit Facility including financial covenants. Recent Events Settlement with the SEC On April 11, 2002, we reached a settlement with the SEC relating to matters that had been under investigation by the SEC since June 2000. In connection with the settlement, we agreed to restate our financial statements as of and for the years ended December 31, 1997 through 2000 and undertake a review of our material internal controls and accounting policies. In addition, as a result of the re-audit of our 2000 and 1999 Consolidated Financial Statements, additional adjustments were recorded. The restatement reflects adjustments which are corrections of errors made in the application of U.S. generally accepted accounting principles (GAAP) and includes (i) adjustments related to the application of the provisions of SFAS No. 13 "Accounting for Leases" and (ii) adjustments that arose as a result of other errors in the application of GAAP. The principal adjustments made to our Condensed Consolidated Financial Statements as of and for the three months ended September 30, 2001, reflect changes discussed in our 2001 Annual Report on Form 10-K. Adoption of SFAS No. 142 "Goodwill and Other Intangible Assets" Effective January 1, 2002, we adopted the provisions of SFAS No. 142 "Goodwill and Other Intangible Assets", which is discussed in our Notes to Consolidated Financial Statements in our 2001 Annual Report on Form 10-K. Accordingly, the amortization of goodwill was discontinued in 2002 and was replaced by annual impairment testing of such goodwill. In addition, we have completed the first step of the SFAS No. 142 goodwill impairment test. Based upon this testing we have identified potential goodwill impairments in the reporting units included in our DMO operating segment. Total DMO goodwill is $63 million as of September 30, 2002. We cannot presently estimate the amount of the potential impairment charge and we expect to finalize step two of the impairment test during the fourth quarter 2002. Any non-cash charge would be retroactively recorded as a cumulative effect of change in accounting principle in the first quarter 2002. Berger Litigation As previously reported, in the class action Berger, et al. v. RIGP, on September 30, 2002, the United States District Court for the Southern District of Illinois entered a final judgment for the plaintiffs and adopted their methodology for calculating damages. In December of 2001, the plaintiffs had submitted papers claiming $284 million pursuant to such methodology. The Company's Retirement Income Guarantee Plan (RIGP) filed an appeal of the court's rulings on liability and damages on October 9, 2002. We believe, based on advice of legal counsel, that it is probable that the judgment will be overturned. The company cannot estimate the amount of loss that might result from this matter. As previously disclosed, any final judgment after appeal would be paid from RIGP assets. However, such payment will require us to make additional contributions to RIGP in the future based on a potential shortfall in the plan assets available to pay other plan liabilities. RIGP denies any wrongdoing and believes it will prevail on appeal. Pensions Market performance over the last two years has decreased the value of the assets held by our pension plans and has correspondingly increased the amount by which our worldwide pension plans are under-funded. We are in the process of estimating the under-funding amount of our major worldwide pension plans. As a result of the decline in the value of our pension plan assets, a decline in interest rates, and the resultant increase in the under-funded pension obligations for certain European and US pension plans, it is likely that we will record a fourth quarter non-cash charge to shareholders' equity, which could total several hundred million dollars. The amount of the under-funded obligation and the non-cash charge will depend on fourth quarter asset returns and interest rate changes. We are contemplating reducing our discount rate and reducing the expected return on plan assets assumptions for our major pension plans in 2003. During the fourth quarter we expect to complete our actuarial assessments for 2003 which will likely increase our 2003 pension expense. In the event that market performance continues to be poor, we would expect that our 2003 pension plan cash funding requirements will increase modestly. Xerox Corporation Securitization In 2000, Xerox Corporation securitized certain accounts receivables in the U.S. generating gross proceeds of $290 million. This transaction was accounted for as a sale of receivables. In May 2002, a Moody's downgrade constituted an event of termination under this agreement, which we have allowed to run off. In October 2002, the counter-party received $231 million of the cash proceeds resulting from the pool of the then existing receivables within the facility of this agreement. We have no further obligation to the counter-party as such facility has been terminated. Forward-Looking Statements This earnings release and financial review contain forward-looking statements and information relating to Xerox that are based on our beliefs as well as assumptions made by and information currently available to us. The words "anticipate," "believe," "estimate," "expect," "intend," "will" and similar expressions, as they relate to us, are intended to identify forward-looking statements. Actual results could differ materially from those projected in such forward-looking statements. Information concerning certain factors that could cause actual results to differ materially is included in the company's second quarter 2002 Form 10-Q filed with the SEC. We do not intend to update these forward-looking statements. Short Name: Xerox Corp. Category Code: QRT Sequence Number: 00001029 Time of Receipt (offset from UTC): 20021023T102426+0100 --30--kam/in* CONTACT: Xerox Corporation James A. Ramsey Director, Investor Relations 203-968-3807 James.Ramsey@usa.xerox.com Fax (203) 968-3944 or Cynthia B. Johnston Manager, Investor Relations 203-968-3489 Cindy.Johnston@usa.xerox.com Fax (203) 968-3944 KEYWORD: UNITED KINGDOM INTERNATIONAL EUROPE INDUSTRY KEYWORD: SOURCE: Xerox Corp. 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